EUR 850.00 For Business Accounts Only

Morningstar | Automatic Data Processing Continues Its Run of Impressive Margin Improvement

Wide-moat rated Automatic Data Processing continued to build on the momentum generated over the past few quarters as total revenue came in at $3.5 billion, representing growth of 8% from last year’s fourth quarter. Even more impressive, it was able to increase pretax earnings by 26% from the previous year to $741 million. This was largely driven by continued improvements in profitability that saw pretax margins increase by 300 basis points. Some of this benefit was driven by slower hiring as the company seeks to replace employees that accepted its early retirement program, but much of the benefit has come from operating leverage as sales growth has accelerated in recent quarters. We’ll be updating our model to include the better-than-expected growth but only expect a modest increase to our $102 fair value estimate.

The company’s ability to hold the line on expenses is particularly impressive. Excluding pass-through expenses, its total operating expenses increased only 2.4%. Much of this improvement is in systems development and programming costs that came in at $156.1 million, about $3.3 million lower than the previous year. Some of this may be driven by lower headcount resulting from the voluntary retirement program. We’ll remind investors the company took a $365 million charge two quarters ago related to its voluntary early retirement program, and the recent improvement in profitability may be attributable to the timing of some of those expenses. Most of the benefit appears to be through lower wages and pension expenses. The company has seen a decrease in capital spending in the first six months of its fiscal year, declining about 12% from the previous year. This may be attributable to the fact that it no longer has to operate redundant technology platforms. However, we will continue to pay close attention to verify that its margin improvement isn’t the result of near-term cost-cuts or accounting maneuvers.

It does seem like CEO Carlos Rodriguez is being thoughtful in regards to cutting expenses and acknowledges that while the company has achieved lowered expenses it hasn’t come without losing valuable experience and product knowledge of employees with longer tenure. In addition, it does seem that while management thinks much of the profitability improvement is sustainable, the recent gains aren’t likely to be continued. Throughout the call, management seemed to signal higher expenses as vacant positions are filled.

Finally, we found the company's comments around workers’ comp underwriting interesting. Recently, acquisition activity among paid employer organizations has heated up. Increasingly, it feels like investors treat the liabilities that Automatic Data Processing or Paychex assumes from worker’s compensation plans as a non-risk. Rodriguez explained that the company hasn’t historically made acquisitions in the space because it’s hard verifying the quality of an insurance portfolio it hasn’t underwritten itself. We appreciate management’s caution, but it also makes us more focused on Paychex’s recent acquisitions in the PEO space and the underlying risks in insurance.